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The oil price…what is happening?

The price of oil suffered an abrupt and dramatic fall in the second half of 2014. US Crude oil fell from $110 per barrel (p/b) to just under $50 p/b, a decline of greater than 50%. No one foresaw this rapid decline in the world’s most valuable and important commodity.

Source: Financial Times, data to 10th February 2015

We will discuss what factors led to the dramatic fall, what a lower oil price means for the global economy and how the P&P portfolios are positioned to benefit from a lower oil price?

What caused the fall in the oil price?

The oil price gently rose through the first half of 2014, as the inception of the war in Eastern Ukraine forced the market to anticipate oil supply disruptions from Russia and the oil price duly rose to $110 p/b. However as we entered June, the price began to fall driven by the markets realisation that there was a vast oversupply of oil in the global market. The oil price fell abruptly to restore the supply demand equilibrium.

Looking at the below chart, the oil price has been stubbornly high at c. $100 p/b in recent years and >$40 p/b over the last decade driven by soaring oil consumption in emerging markets such as China and conflicts in key oil producing nations such as Iraq, Libya and Syria. However during this time, oil production in conventional fields, such as the North Sea, were unable to keep up with global demand due to their maturity and the oil price had to rise as demand outstripped supply. The higher oil price spurred greater innovation in the oil industry leading to the shale oil revolution in North America and the rise of unconventional drilling known as “fracking”. This led to an oil boom in North America and a vast amount of supply was added each year with the US alone adding 4 million extra barrels per day to global production - the US is now the largest oil producer in the world. Why did the market miss it? At the same time as the US oil boom, war and conflict halted production in the Middle East particularly in large producers of Libya and Iraq, however as these streams have come back on line coupled with continued rapid production in the US, supply has rocketed.

Source: Bloomberg Data, data to 31st December 2014

Another important factor in the oil price fall is the action or inaction of OPEC (Organization of the Petroleum Exporting Countries). On the 25th November 2014, the OPEC cartel met to discuss the falling oil price and its impact on future production, however to the surprise of the market they did not cut production to support the price and the oil price slid into bear market territory. OPEC supply 40% of the world’s oil and historically use their power to set the price however their inaction suggests they are aiming to regain market power by squeezing the higher cost oil producers in the US out of the market.

What does it mean for the global economy?

I believe it will be a major positive for the global economy and global growth. 89% of global GDP is generated in countries that are net importers of oil, implying that the countries responsible for generating the vast majority of global economic output will have significantly cheaper input costs, therefore leading to even greater potential output. The major beneficiaries are largest economic regions in the world of the US, China, Japan and Europe, all of which are major net importers of oil. The IMF predicts a boost to global economic growth of 0.3 - 0.7% in 2015 and 0.4 - 0.8% in 2016.

Above is a chart provided by Neptune Investment Management, illustrating the uplift to GDP from an average oil price of $60 p/b in 2015. Neptune expect the global economy to experience a 0.5% boost to growth, with developed countries gaining 0.5% and Emerging Market (EM) countries that import oil to gain an additional 1% growth however Emerging Market oil exporters such as Russia, Brazil, Venezuela and countries in the Middle East will witness a reduction in economic growth, given their overreliance on oil (see the above graph).

How are the P&P Portfolios positioned to benefit from the lower oil price?

The P&P portfolios are positioned to benefit from improving global economic growth and any incremental growth boost from the lower oil price. Consequently the P&P portfolios are overweight growth assets such as Equities and are underweight defensive assets such as Fixed Interest. The portfolios equity allocation has 90% exposure to developed market equities and the remaining 10% exposure is to emerging market equities. The developed market exposure is primarily through UK, US and Japanese equities, all of whom are large net importers of oil and their economies should greatly benefit from cheaper oil. Although the US is the world’s largest producer of oil, it still imports c. 40% of its yearly oil consumption. The emerging market exposure has a strong bias towards Asia, particularly China and India, again both of whom are oil scarce economies and are net beneficiaries of cheaper oil. The P&P portfolio allocation is driven by valuation, economic fundamentals and the impact on portfolio risk, and we believe the above allocation provides attractive value supported by robust economic fundamentals and strong diversification benefits within a balanced multi-asset portfolio.

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